Banishing the ghost of 1937

So the big day is finally here.   Will patience be a virtue, or won't it?   Macro Man's hunch is that the Fed will keep the door ajar for a midyear rate increase, but maintain a pretty high bar for doing so.  Judging by yesterday's survey results, he has plenty of company.  Fully half of you opted for answer C, "Indicate that a June hike is possible but unlikely."   Only a third of you thought that the market's perceived probability of a rate hike in three months' time will increase as a result of today's Fedapalooza.

In terms of his portfolio, Macro Man has decided to more or less sit tight.  As discussed yesterday, he has a bit of a barbell on, with positions in those assets most and least priced for a hawkish outcome. Judging by both the poll result and yesterday's little short-covering flurry in EUR/USD, a bit of a damp squib today would not come as any real surprise.  Macro Man's positions are pretty modest at the moment, so he's willing to wear a little bit of short term pain if it means getting better entry levels to reload.

Your author was intrigued to see the flurry of press attention paid to Ray Dalio's warning on a 1937 repeat from the Fed.   Only a few miles separate Macro Man's office from Mr. Dalio's, though the distance between their respective places in the financial universe is obviously substantially greater.  Still, Mr. Dalio is a famous adherent of brutal honesty, so Macro Man can't help but observe that he thinks Mr. Bridgewater, a man who's been known to hold the odd bond or ten billion, is talking his book a bit.

Although Macro Man has not read the verbatim text of Dalio's missive, based on press reports it seems to him that Dalio is falling prey to the fallacy of the false dichotomy discussed last week.   The Fed can raise rates modestly and still maintain easy financial conditions, even if the feedback loop between the policy rate and overall financial conditions is swifter and stronger than it was in the past.

Moreover, "we can't raise rates because it might precipitate another crisis" is a counterfactual that can neither be proven or disproven  unless someone's willing to give rate hikes a go.   What we can say, however, is that there is no room for orthodox policy easing should the need arise from current policy settings.   And of course, if unorthodox measures were all that effective, Mr. Dalio wouldn't be sitting here in 2015 fretting about the economy's ability to withstand any tightening whatsoever!

To be sure, some emerging markets with an excess of dollar funding may be vulnerable.   Of course, many of the countries moaning about potential Fed tightening since the taper tantrum were the very same ones that whinged when the Fed was doing QE!   There's just no pleasing some people....

As for the state of the economy, summoning the ghost of 1937 really misrepresents where we are and where we have been.  It's true that industrial production is roughly 5% above its pre-crisis peak, the same level as it was when the Fed started tightening in 1937.  However, the paths to that level were very different indeed....

While growth in the rest of the world has clearly been anemic since the onset of the crisis, it's worth reminding ourselves that anemic is a damned far way from catastrophic.   In 1937, US exports of goods and services were only 2/3 of their pre crisis peak.  Last year they exceeded 2008's levels by 26%.

Finally, let us note that the Fed tightened policy in 1937 as the unemployment rate tumbled from a Depression high....all the way down to 11%!    Lest you have forgotten, the peak unemployment rate during the Great Recession was 10%.   It's true that U6 was as high as 17% a few years ago....but we also don't know what the equivalent would have been in the 1930's.  Regardless, in 1937 the unemployment rate had only retraced slightly more than 50% of its rise from the pre-crisis trough, substantially less than it has done over the past five years.

None of this is to say that tightening won't have some negative repercussions- after all, you can't make an omelet without breaking a few eggs.  On the other hand, Japan offers a salutary lesson that perma-ZIRP is no buffer against economic downturn or financial crisis.  Unlike Japan, the United States has returned to solidly positive nominal GDP growth (albeit lower than pre-crisis trends.)  Perhaps the question that Mr. Dalio really should be asking is what he'd like the Fed to do when the next downturn comes (and come it will, ZIRP or no ZIRP): cut rates from  2.50%, or push on a string?